On Attacking Austrian Economics

Josh Barro of Bloomberg has an interesting theory. According to him, conservatives in modern day America have become so infatuated with the school of Austrian economics that they no longer listen to reason. It is because of this diehard obsession that they reject all empirical evidence and refuse to change their favorable views of laissez faire capitalism following the financial crisis. Basically, because the conservative movement is so smitten with the works of Ludwig von Mises and F.A. Hayek, they see no need to pose any intellectual challenge to the idea that the economy desperately needs to be guided along by an “always knows best” government; much like a parent to a child. CNN and Newsweek contributor David Frum has jumped on board with Barro and levels the same critique of conservatives while complaining that not enough of them follow Milton Friedman anymore.

To put this as nicely as possible, Barro and Frum aren’t just incorrect; they have put their embarrassingly ignorant understandings of Austrian economics on full display for all to see.

First off, no conservative, besides perhaps Michele Bachman, has shown any interest in the Austrian school as of late. In most aspects, Ron Paul can hardly be considered a conservative. If Frum, with all his political credentials, can show me another true blooded conservative that has read through Human Action or Man, Economy, and State, I am all ears. The fact remains that traditional conservatives aren’t brushing up on their Mises when they aren’t attending Tea Party rallies or asking their Congressman to nuke Iran into smithereens.

On the subject of Austrian economics itself; the school isn’t against empirical evidence per say. What it opposes is methodological positivism which is using empirical data by itself to formulate theories about how an economy functions.

Austrians don’t see the social sciences as one in the same with the physical sciences like chemistry. Closed experiments can’t be conducted on humans that will always yield the exact same results. Because humans posses the ability to make choices, there are no constants in human behavior. As economist Robert Wenzel puts it

In the science of physics, we know that water freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed.

There are no such constants in the field of economics since the science of economics deals with human action, which can change at any time.

Austrian economics relies on deductive reasoning and one a priori law that Ludwig von Mises worded as “human action is purposeful behavior.” That is, man acts to achieve ends or otherwise he would not act. This statement is what Murray Rothbard, considerably the most known Austrian economist next to Mises and Hayek, called “radically empirical” since it is absolutely self evident to any observer. A few subsidiary axioms can then be derived from the human action axiom such as “individuals vary” and that people “regard leisure as a valuable good.”

Austrians don’t reject empirical evidence but look at it with the theory of human action in mind. They don’t see an increase in ice cream sales coinciding with an increase in kidnappings and automatically assume that as people eat more ice cream, they become more prone to abducting people. They may consider that because warmer weather tends to result in more people going outside for leisurely activity, the opportunities for kidnappings to occur increases as does the appetite for ice cream. This isn’t a rejection of empirical evidence but merely viewing the world with a theory to help explain the complex happenings of society.

As for the financial crisis which should have changed the minds of the true believers, if Barro or Frum were paying even the slightest amount of attention to the Austrian school during the run up to the housing bubble burst, they would have seen a number of warnings from those versed in Misean economics. This includes Gary North, Robert Wenzel, Doug French, Jim Rogers, Hans Sennholz, Frank Shostak, Ron Paul, and Peter Schiff. Austrian economist Mark Thorton even wrote this back in 2004:

It has now been three years since the U.S. stock market crash. Greenspan has indicated that interest rates could soon reverse their course, while longer-term interest rates have already moved higher. Higher interest rates should trigger a reversal in the housing market and expose the fallacies of the new paradigm, including how the housing boom has helped cover up increases in price inflation. Unfortunately, this exposure will hurt homeowners and the larger problem could hit the American taxpayer, who could be forced to bailout the banks and government-sponsored mortgage guarantors who have encouraged irresponsible lending practices.

So how did so many observers that understood Austrian economics see a crisis on the horizon? Unbeknownst to Barro and Frum, the school has a theory that explains why economic booms and busts are a product of money supply manipulation by a central bank and fractional reserve banking. The Austrian Business Cycle theory stipulates that as credit expansion occurs unbacked by real savings, an inflationary boom takes hold where many are deceived into believing themselves richer than they truly are. As the money supply is increased by a central bank, so too are banks enticed to expand credit. As Rothbard explains:

Businesses, in short, happily borrow the newly expanded bank money that is coming to them at cheaper rates; they use the money to invest in capital goods, and eventually this money gets paid out in higher rents to land, and higher wages to workers in the capital goods industries. The increased business demand bids up labor costs, but businesses think they can pay these higher costs because they have been fooled by the government-and-bank intervention in the loan market and its decisively important tampering with the interest-rate signal of the marketplace.

This credit expansion is fully sanctioned by the government that not only provides a public backstop to banks that may find themselves insolvent but also join the bandwagon of taking advantage of cheap borrowing costs. As the inflationary boom wears on, capital is consumed as more and more of the public get caught up in the exuberance. When the money supply expansion inevitably ends (as it must less the complete destruction of the currency takes hold), the market and prices must readjust accordingly as malinvestments finally come to light. During the boom the production structure of the economy is distorted to the point where both increased investment in capital goods and increased consumer spending tend to take place. Put simply, credit expansion throws off what would otherwise be a natural rate of consumption and saving. Once it is realized that producer goods have been bid up far too high to be purchased with existing savings, prices must fall and losses are felt. This is precisely how the recent housing bubble played out as the price of homes, which are generally considered good investments, reached a point too high to be mass marketable. As economist Joseph Salerno documents:

The events of 9/11 led the Fed to ratchet up its expansionary monetary policy. From the beginning of 2001 to the end of 2005, the Fed’s MZM monetary aggregate increased by about $1 billon per week and the M2 aggregate by about $750 million per week. During the same period the monetary base, which is completely controlled by the Fed, increased by about $200 billion, a cumulative increase of 33.3 percent.

The Federal Funds rate was driven down below 2 percent and held there for almost three years, pegged at 1 percent for a year (Figure 5). The result was that the real interest rate, as measured by the difference between the Federal Funds rate and headline CPI, was negative from roughly 2003 to 2005. Rates on 30-year conventional mortgages fell sharply from over 7 percent in 2002 to a low of 5.25 percent in 2003 and, aside from brief upticks in 2003 and again in 2004, fluctuated between 5.5 percent and 6.0 percent until late 2005 (Figure 6). Perhaps, more significantly, 1-year ARM rates plummeted from a high of 7.17 percent in 2000 to a low of 3.74 percent in 2003, rising to 4.1 percent in 2004 and to slightly over 5 percent in 2005. In addition, credit standards were loosened and unconventional mortgages, including interest-only, negative equity, and no-down-payment mortgages, proliferated.

When housing prices began to fall, so did the perception of wealth by homeowners, mortgage lenders, and house flippers. Because the global economy is so interconnected, the unemployment that occurs in just one industry has a devastating ripple effect. When the housing bubble finally popped, recession set in as the economy contracted.

Barro and Frum have given no indication that they are familiar with the Austrian theory of the trade cycle. Where they come off as critical of the school is its preferred solution to economic recession.

Austrians stress the importance of prices as signals to all economic actors. Because prices are so vital to market coordination, they must be allowed to adjust to a new normal defined by the new spending and investment patterns. Anything the government does to prevent the painful but necessary readjustment from occurring (such as bailing out politically favored industries, enacting price and wage controls, subsidizing the unemployed, or providing loans in the form of taxpayer dollars to businesses that would otherwise be unable to afford their borrowing costs) puts the brakes on the recovery. This is why Austrians are against all government interference in the marketplace to prevent a much needed correction following a bust caused predominantly by the government’s own inflationist agenda.

None of this is a blind allegiance to an ideology. The laissez faire attitude among Austrians is rooted in an understanding of the complexities of the marketplace and the vital importance of capital and production. Perhaps more importantly, many followers of the school see modern day banking for what it really is: a racket based on fractional reserve lending that is held together by both the government and its central bank’s promise to guarantee its solvency. Barro claims that his own opinions on monetary policy and banking regulation have changed since the financial crisis. Unlike many Austrians, he never saw the crisis coming. He has no systematic theory to explain why the bubble occurred and what steps are needed to prevent it from happening again. Hilariously, Barro has admitted to attempting to read Mises’ grand treatise Human Action but that he couldn’t understand it and therefore claims “it actually makes no sense.” Upon reading select chapters from Human Action, even the most casual reader would see that Mises doesn’t completely reject the use of empirical data as Barro claims. What the economist needs, according to Mises, is “the power to think clearly and to discern in the wilderness of events what is essential from what is merely accidental.” That means looking at historical data with a correct understanding on market functions to be able to interpret it so it makes sense and provides a possible explanation for outliers.

When it comes to conservatives “dumping” Milton Friedman as David Frum laments, all this writer can say is good riddance. Friedman was as statist as they come. From his advocacy for the dreaded “withholding tax” while employed by the U.S. Treasury to his comfortableness with the Federal Reserve, Friedman was hardly the liberty fighter he is often made out to be. Yes, he has provided some eloquent defenses of capitalism and the morality of free choice. But as Rothbard made sure to point out way back in 1971:

And so, as we examine Milton Friedman’s credentials to be the leader of free-market economics, we arrive at the chilling conclusion that it is difficult to consider him a free-market economist at all.

At the same time, we find Friedman calling for absolute control by the State over the supply of money – a crucial part of the market economy. Whenever the government has, fitfully and almost by accident, stopped increasing the money supply (as Nixon did for several months in the latter half of 1969), Milton Friedman has been there to raise the banner of inflation once again. And wherever we turn, we find Milton Friedman, proposing not measures on behalf of liberty, not programs to whittle away the Leviathan State, but measures to make the power of that State more efficient, and hence, at bottom, more terrible.

And while Friedman famously argued, along with Anna Schwartz, that blame for the Great Depression should be laid on the Federal Reserve’s reluctance to offset the declining money supply, Rothbard (alone at the time) argued that it was because of the Fed’s previous inflationary policy in the latter half of the 1920s that a stock market bubble and real estate really took off. Because the inflation was hidden in the rise of certain asset prices and overall increases in productivity, many economists missed the Fed’s role in the boom. Additionally, Rothbard concluded in his much overlooked book America’s Great Depression that the Depression really became great because of Herbert Hoover’s unprecedented interventionist policy of massive increases in government expenditures, the propping up of wages, price supports, and the enactment of protectionist tariffs. Though Friedman’s view is still held as the conventional explanation for the Depression, especially by Federal Reserve chairman Ben Bernanke, Rothbard’s explanation is attracting more followers by the day. Back in 2009, eminent UCLA economist Lee E. Ohanian even published a working paper for the Journal of Economic Theory that supported much of Rothbard’s explanation for the Depression.

In the end, all Josh Barro’s attack on Austrian economics shows is his utter lack of knowledge on the subject. To claim that conservatives are devout followers of the school is incredibly misleading. Mitt Romney isn’t brushing up on his Mises or Hayek during campaign stops. Rush Limbaugh isn’t reciting essays by Rothbard on his radio show. And Sean Hannity isn’t lecturing his viewers on the nuances of the Austrian Business Cycle theory. The Federal Reserve only became a topic of discussion during the past Republican primary race because of Ron Paul’s ability to make it a relevant issue.

Barro claims to have a bookshelf of Austrian literature. He would do well to crack open a book sometime as he desperately needs a refresher course. David Frum would be just as wise to check out the Austrian school for himself rather than learn it second hand from someone who clearly doesn’t have a firm grasp on the subject.